Understanding Construction Financing When Building a Home

You’re ready for a new home. You’ve searched listing after listing but nothing strikes your fancy. Then you decide you want to build your own home. You’ve heard about construction financing but you weren’t sure exactly how such loans worked. Here are a few points on what makes them different.

First, they are loans taken out by the buyer in most cases. Prior to the collapse of the housing market and the start of the recession, the builders were better able to take them out. Most of these loans are also only granted by a bank if you already have a banking relationship with them.

They do this to protect their assets, since there is no completed collateral for the loan. If you are building on land you already own, you can use it as collateral to try to get better terms. The bank will also monitor the process to ensure that the home is progressing as it should.

Construction loans are designed to help finance the actual building of the house. They are a short-term loan with a term length of one year. The interest rates vary with the prime rate, so there is a chance of the loan payment amount increasing dramatically if the interest rate climbs quickly. Add to that the fact that the interest rate on a construction loan is higher than a mortgage to begin with, and this can be a lot of money.

Why is a construction loan higher? The loans are often riskier and they are not as much in demand, making them more expensive for banks. There is no tangible product for them to fund, at least at the start, so they are funding a dream. Construction loans are not always available in every market, either.

So what information will you need to take to your bank? They will start by asking to see what timeline you have for completion. It needs to be a realistic timeline, too, since the bank will be checking the progress, so be sure you consider any possible weather delays. You will also need to take in the budget you have for the project so they can allocate the right amount of funds. Lastly, take them the plans of the house so they can get an idea of the scope of the project.

What happens next? The bank grants a loan with funds able to be withdrawn as needed based on the construction plan. Payments will need to be made on a regular basis. Often at the beginning of the loan, most of that money goes towards interest only. At each of the stages, the bank will send someone out to inspect the progress.

Once the house is completed, the bank will require a few documents to be turned in to them. These often include a certificate of occupancy and lien releases from the contractors and subcontractors. If the bank is satisfied, they will turn the loan into a regular mortgage. This process is called construction to permanent financing. Terms are usually 30 years.